How mortgages trap the unwary
VARIABLE RATE PAYMENT USEFUL BUT ALSO RISKY
By Mark Schwanhausser
Mercury News

The right mortgage can help you stretch into a home you didn't think you could afford. But beware: What you don't know about your mortgage might stretch you past the breaking point.

To understand what you are buying you must understand the basic characteristics of mortgages, especially if you are buying an adjustable-rate mortgage, or ARM. These variables can make a dramatic difference in the size of your monthly mortgage payment, how much your payment can vault at one time, and the costs to refinance. (See glossary for more details.)

Homeowners frequently have a feeble grasp of such details.

According to a Federal Reserve study in January, 41 percent of homeowners with adjustable loans didn't know the maximum interest rate they could be charged, 35 percent didn't know how much the rate they're charged could rise at one time, and 17 percent didn't know how frequently their monthly payments could change.

In Silicon Valley, where high home prices make buyers more apt to seek riskier adjustable-rate and interest-only loans, it is especially important that you understand the terms of your loan.

Experts strongly recommend that you calculate best- and worst-case scenarios for any loan you're considering to make sure you can afford the monthly payments you might face. To Jack M. Guttentag, a finance professor emeritus of Wharton School at the University of Pennsylvania, the best case is that interest rates don't rise. He contrasts that with a scenario in which rates rise 1 percent a year for five years.

The most conservative method, though, is to calculate how much you would owe if interest rates were to rise fast enough to make your payments balloon to their largest possible size.

``The worst case is unlikely to materialize, but it could,'' said Guttentag, who has developed a Web site rich with mortgage advice and calculators at www.mtgprofessor.com. ``There's certainly a lot of comfort in knowing you could deal with the worst case.''

Let's take the payment-option ARM that is especially popular in the Bay Area's high-priced housing market. These loans let you choose each month whether to make a full payment, pay just the interest or pay just a portion of the interest.

When you don't pay all the interest, the difference is added to the amount you owe as ``negative amortization.'' That can leave you owing more than you initially borrowed -- and you could face a huge jump in your payments if you build up too much negative amortization.

On his Web site, Guttentag evaluates a hypothetical 30-year ARM with a 1.25 percent teaser rate that adjusts after five years. By changing one variable in the formula, the monthly payment can jump 16 to 59 percent even if interest rates remain flat. But under his rising-rate scenario the payments can rocket from 58 to 176 percent in one month.

Though it isn't an industry standard, Melissa Richards, general counsel for the California Mortgage Bankers Association, encourages lenders to assess whether borrowers could handle payments for at least five years. That gives borrowers a buffer if home prices slump or personal circumstances make it hard to refinance or sell their homes.

Lenders who gauge a borrower's ability to pay for less than five years are ``setting up that homeowner for payment shock probably earlier than they expect and before they have an opportunity for improving their financial situation,'' Richards said.

``Of course,'' she added, ``the industry push-back has been, `Yeah, well, we have to get people into loans, you know.' ''

Nationally, federal banking regulators have proposed guidelines to rein in lenders peddling loans that offer below-market introductory teaser rates, interest-only loans and payment-option loans that permit payments that don't cover even the interest. One goal is to ensure that lenders more thoroughly evaluate a borrower's ability to pay adjustable-rate loans as monthly payments ratchet higher.

In January, the mortgage industry's reputation was rocked when Ameriquest Mortgage agreed to a $325 million settlement with California and 48 other states over a laundry list of alleged deceptive acts and practices involving more than 725,000 borrowers.

Though the Orange-based lender denied wrongdoing, it agreed to adopt practices that borrowers might mistakenly assume are standard. Chief among them: Loan officers must clearly spell out how their mortgages work, they won't be rewarded for steering borrowers into loans with higher fees and prepayment penalties, and they'll be prohibited from encouraging applicants to lie about their income.

California Attorney General Bill Lockyer, who joined the Ameriquest suit, also is examining deals in which lenders pay bonuses to mortgage brokers who place borrowers in loans with higher-interest rates. Critics say these ``yield spread premiums'' are disclosed to borrowers only after the loan-application process is well under way, and even then are not expressed in a way many consumers can understand.

``Buying a home should be the fulfillment of a dream, not the beginning of a nightmare,'' Lockyer said in an e-mail to the Mercury News. ``Do the homework, ask the questions and get the answers you need to make sure you're getting the best possible deal for you, not the bank or the broker.''
Contact Mark Schwanhausser at mschwanhausser @mercurynews.com or (408) 920-5543.

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